Tuesday, January 31, 2006

The China Bubble

December 20th, 2006 - Motley Fool

In the late 1980's and early 1990's, the world witnessed a bubble economy in Japan. Soon after, we experienced the tech bubble here in the U.S. Now people are wondering if there is a real estate bubble. I hate to be the bearer of more bad news on the bubble front, but there's yet another one on the horizon. The ever-growing Chinese market, a topic which dominated the financial press in 2005, has become overheated, and the consequences could be dire for the global economy.

Back in June 2005, I warned investors that even a mild slowdown in the U.S. economy could send the Chinese economy into a tailspin, possibly throwing one of the world's largest and fastest-growing economies into a Japan-like deflation.

Why should we care about what happens to China? As New York Times columnist Thomas Friedman put it in his book, the world is now flat. The amusing saying, "What happens in Vegas, stays in Vegas," doesn't apply to world economics, especially when it comes to fungible (that is, exchangeable or substitutable) commodities like oil. What happens in China now impacts the rest of the world. Metternich's old line about Paris sneezing and Europe catching the flu has come true on a global scale.

Unlike the oil crisis of 1970s, the rise in the price of oil to $60 per barrel was caused not by a shortage of supplies, but by increased demand, especially from the fast-growing Chinese economy. According to the Energy Information Administration, in 2004 China became the second-largest consumer of oil after the United States. It was the source of around 40% of the world's oil demand growth over the past four years, with year-over-year growth of 1 million barrels a day in 2004.

However, the pendulum swings both ways. Just as an increase in demand drove oil prices to all-time highs, its decrease (driven by a slowdown in the Chinese economy) is likely to deflate oil prices below conventionally expected levels. Oil stocks like Chevron(NYSE: CVX), ExxonMobil(NYSE: XOM), ConocoPhillips(NYSE: COP) and many others that were great performers in 2005 are likely to be the first casualties of the bubble pop. Many of the big oil companies are struggling to increase their production, and the price of oil is the wild card that drives their earnings growth.

Most observers can't imagine a pop in the Chinese bubble -- but they felt the same way back in the late 1980s about Japan. Its ultimate collapse led to a fifteen-year recession. Alas, the Chinese government's close involvement in running its economy complicates matters even further, as it may try to sustain the rapid growth for as long as possible. History (and Japan's own case) show that the longer the government tries to support ailing companies, the more painful the economic reckoning will be.

The possible deflation in China has serious ramifications for other industrial commodities, including copper and steel, but it goes a lot further than just that. China has become a de facto manufacturer for the world. Industrial production accounts for 53% of its GDP, according to the CIA World Factbook. That's double the rate of most developed nations. The following chart shows how China compares with the U.S., U.K. and Japan.

(Please follow this link to see the chart)

Chinese economic growth is largely driven by the manufacturing sector; its industrial production is growing at double the rate of GDP. Any company that competes with Chinese rivals in manufacturing will face even greater competition once China is thrown into a deflationary environment, since the incentives to lower prices when fixed costs are high are too great to resist.

China will likely continue to dominate the business pages in the near future. Unfortunately, the stories may not all be so positive.

Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He also writes for the Financial Times and Minyanville.com. His firm has a position in Exxon Mobil. The Motley Fool has a disclosure policy.

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Wednesday, January 04, 2006

Natural disasters may herald a 'hard' market

January 4th, 2005 - Financial Times

Last year's rendezvous of three witches (Rita, Katrina and Wilma) on the Gulf coast caused destruction and sucked out capital from the property and casualty insurance industry.

The bad news is: insurance companies lost a lot of money. But the good news is: insurance companies lost a lot of money. Thus we are likely facing a new "hard" market, of increasing prices. If you are an investor in the sector, rather than a buyer of insurance, that is good news - provided the likes of the three witches don't pay the US another visit next year, or the small earthquake California felt in December was not a prelude for a larger one.

There is, however, a good way to participate in the upside of the rising insurance premiums without bearing the risk of a natural disaster - insurance brokers. They are hired by companies (from mom and pops to Fortune 100 companies) to find an appropriate insurance coverage at the best price. Insurance brokers are transaction facilitators, enjoying the upside of rising premiums since their commissions rise with premiums, but at the same time they are not risking their balance sheets, which is the insurance companies' job.

AJ Gallagher (AJG) is the best play in the broker industry: it has the highest dividend yield (3.6 per cent), one of the lowest valuations, virtually no debt, a very respectable 20 per cent return on capital and it is trading at 16 times 2006 earnings, which are likely to be revised upwards as the market hardens. It has a good management team, headed by Pat Gallagher - the third Gallagher to run the company since it started in the suburbs of Chicago 77 years ago - which has shown a commitment to long-term growth even if it means making sacrifices to short-term profitability. This is a rare quality in today's often short-sighted corporate environment.

In the past decade AJG has grown earnings per share at about 14 per cent a year. Long term growth is likely to be somewhat in line with the past, with 7-8 per cent coming from organic growth and the rest from acquisitions, though I expect sales growth over next couple years to be higher, driven by firming (hardening) of the insurance market. I am usually not a big fan of acquisitions as they introduce an execution risk to the business and are often done to build corporate empires, not for the benefit of shareholders. However, that is not the case with AJ Gallagher. It has perfected the art of making small acquisitions that effectively involve hiring an office of insurance agents (usually 10 to 20) that share a similar culture and goals.

A grey cloud in the person of Eliot Spitzer is hovering over insurance brokerage stocks, but that could dissipate soon. All top insurance brokers, including AJ Gallagher, stopped taking contingent commissions (which according to Mr. Spitzer created a conflict of interest for insurance brokers) and paid fines. To offset loss of contingent commissions, insurance brokers are negotiating with insurance companies to raise their normal commission thus making their compensation transparent to their clients.

AJ Gallagher has shown a remarkable ability to create shareholder value, and grow earnings and cash flows in any market environment (hard or soft). Using Warren Buffett's analogy: it is one of those rare stocks that I would feel comfortable holding even if the stock market were closed for the next ten years and I could not sell it.

Vitaliy Katsenelson is a portfolio manager at Investment Management Associates and teaches at the University of Colorado in Denver. His funds hold AJ Gallagher stock

Vitaliy N. Katsenelson, CFA

This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.